Chapter 2. Cost Management

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CHAPTER TWO: COST

MANAGEMENT
• 2 . 1 An important part of project
management is the project cost
management. It covers the scope of
cost estimations and budgeting.
Moreover, cost control ensures that
the project stays with in the financial
boarders which are defined in the
budgeting process.
1-1
 Although the estimation, budgeting and
control of costs are defined as three
unaffiliated processes in theory, they are
strongly related and interacting.
S i g n i f i c a n t f o r t h e p r o j e c t c o
s t management is its concentration on
the cost generated by the performance of
the project schedule.
 But in addition to this, it should also deal
with the effects of the cost management
decisions on the project deliverable in the
form of ‘life cycle costing’.
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 For example, saving costs in research
and development in construction
phase could decrease the quality of
the final goods and therefore, puts
the project’s objectives at a risk.
 The way the project cost
management is dealt with varies
according to
1. the different requirements of each
project. Eg. Industrial
manufacturing products, financial
sectors.
2. The ways and points of time measuring
of the project costs have to be
adapted to the project’s character.
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3. To the special needs of the
individual stakeholders.
 In order to estimate the project cost
and to generate an a p p r o p r i a t e
budget, i t i s necessary to have an
overview of the different kinds of
costs that are implemented in the
nature of projects.
 One can define main types of costs,
which are the direct costs( direct
materials and direct labor), the
overheads and the general &
administrative costs.
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2.2 Classification of Costs( eg a mfg project)

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 The direct costs are the most
important costs in project cost
management( prime costs).
 The projects cost management’s
task in cost e s t i m a t i n g i s to
e x a mi n e the different
possibilities to spend costs in
various project steps.
 Input for the estimation of costs
of a single activity from the
project’s schedule are the amounts
of all resources which are required
to perform that activity. 1-6
 Another document which provides
necessary information to facilitate the
creation of the cost estimate is the
Work Breakdown Structure(WBS).
 WBS describes all tasks that are
included in t h e p r o j e c t ’ s p r o g r
e s s e s a n d t h e i r relationship.
 A general overview about the
execution, monitoring and
controlling of the project is provided
by the project management plan.
1-7
2.3. Processes of cost management
 Many i nputs are r e q u i r e d t o
creat e a comprehensive project cost
plan.
1. The environmental factors have to be
stated( e.g marketplace conditions: available
products and services on the market and by
whom they are supplied.
2. . The c o n s i d e r a t i o n o f w e l l - k n o w
n d a t a a n d predetermined
approaches(prearranged policies in the
organizations like operation boundaries).
3. Schedule management plan(lists of
activities, duration of activities and resources
requirement).
.Such type of cost estimate is called top-down.
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2.4The earned value terms and
formulas:
 It is one thing to meet a project deadline at
any cost. It is another to do it for a
reasonable cost. Project cost control is
concerned with ensuring that projects stay
within their budgets, while getting the
work done on time and at the correct quality.
 One system for doing this, called earned
value analysis, was developed in the 1960s
to allow the government to decide whether
a contractor should receive a progress
payment for work done. The method is
finally coming into its own outside
government projects, and it is considered the
correct way to monitor and control almost
any project. The method is also called simply
variance analysis.
1-9
 One of the primary jobs of a project
manager is to manage trade-offs among
time, cost and performance/scope/[ex: •Can
reduce time by increasing costs; or Can reduce performance by
reducing costs]
9/5/2023
Takele Fufa, PhD
2.5The Profitability Measures (ROS,
ROI, NPV, IRR and BCR)

 Project managers are often


called upon to be active
participants during the
benefit- to- cost analysis of
project selection. It is highly
unlikely that companies will
approve a project where the
costs exceed the benefits.
Benefits can be measured in
either financial or
nonfinancial terms. 1-11
 The process of identifying the
financial benefits is called capital
budgeting, which may be defined as
the decision-making process by
which organizations evaluate
projects that include the purchase of
major fixed assets such as buildings,
machinery, and equipment.
 Sophisticated capital budgeting
techniques t a k e i n t o c o n s i d e r
a t i o n d e p r e c i a t i o n schedules,
tax information, and cash flow.
 Since only the principles of capital
budgeting will be discussed in this
text, we will restrict ourselves to the
following topics: 1-12
1. Payback Period

 The payback period is the exact


length of time needed for a firm to
recover its initial investment as
calculated from cash inflows.
Payback period is the least precise
of all capital budgeting methods
because the calculations are in
dollars and not adjusted for the
time value of money
1-13
 Project A will last for exactly five years
with the cash inflows shown. The
payback period will be exactly four
years. If the cash inflow in Year 4 were
$6,000 instead of $5,000, then the
payback period would be three years
and 10 months.
 The problem with the payback method is that
$5,000 received in Year 4 is not worth $ 5 , 000
today. This unsophisticated approach
mandates that the payback method be used as a
supplemental tool to accompany other methods.
1-14
2. NET PRESENT VALUE (NPV)

 The net present value (NPV) method


is a sophisticated capital budgeting
technique that equates the
discounted cash flows against the
initial investment.
 where FV is the future value of the cash inflows, II represents
the initial investment, and k is the discount rate equal to the
firm’s cost of capital.
Consider the previous
example
1-16
3. INTERNAL RATE OF RETURN (IRR)

 The internal rate of return (IRR) is


perhaps the most sophisticated
capital budgeting technique and also
more difficult to calculate than NPV.
The internal rate of return is the
discount rate where the present value
of the cash inflows exactly equals
the initial investment. In other
words, IRR is the discount rate when
NPV=0.
1-17
 The solution to problems involving
IRR is basically a trial-and-error
solution.
 Table below shows that with the
cash inflows provided, and with
a $5,000 initial investment, an IRR
of 10% yielded a value of $3,722
for NPV. Therefore, as a second
guess, we should try a value
greater than 10% for IRR to
generate a zero value for NPV.
Table below shows the final
calculation.
1-18
 The table implies that the cash inflows
are equivalent to a 31% return on
investment. Therefore, if the cost of
capital were 10%,this would be an
excellent investment. Also, this project
is “probably” superior to other projects
with a lower value for IRR.
1-19
4. Benefit Cost Ratio( Profitability
Index)

 The profitability index, also called benefit - cost ratio,


is the ratio of the PV of the future net cash inflows to
the initial outlay of the project.

• It measures the desirability of the project and


evaluates the worth of an investment.
PI = PV (NCF)
PV (IO)
• In the application of PI, a project is accepted if PI
> 1, rejected if PI < 1 and we remain indifferent
if PI = 1. It should be noted that when PI > 1, NPV
is positive; PI < 1, NPV is negative and PI=1 when
NPV is zero.
Example

After tax cash flows of a small scale


tannery project is given below. Find
the profitability index if discount rate is
assumed to be 12%?
1-21
…Cont’
d
Solutions
Year Cash Flow Rate = (12%) PV
1 15,000 0.893 13,395
2 14,000 0.797 11,158
3 13,000 0.712 9,256
4 12,000 0.636 7,636
5 11,000 0.567 6,237
Total 47,678
Therefore, PI = 47,678 = 1.192
40,000

Takele Fufa, PhD


5. Return on Investment (ROI)
 ROI is simply calculated as “earnings”
over “investment”.
 “Earnings” and “investment” must be
defined; often, earnings is defined
as operating income and investment
is defined as average operating assets,
so that
R O I O p e r a t in g in c o m e
= Average operat
in g assets
 Operating assets include cash, A/R,
inventory, and the property and
equipment used in producing the
revenue.
 DuPont analysis is a particularly
useful decomposition of ROI.
ROI = Investment turnover x Return on
sales
 Where,Investment Revenue
Average operating
turnover = assets
Return on sales Operating
= income
Revenue
• DuPont analysis can be used to
determine ways that ROI can be
improved.
1-24
ROI and DuPont Analysis Example
Altus Industries has two divisions, North and South. Use DuPont
analysis to decompose the ROI for each divisions and discuss.

North South
Operating income $180,00 $40,00
0 0
After-tax operating 120,000 24,000
income
Average operating 2,000,00 200,00
assets 0 0
Average current 400,000 36,000
liabilities
Net sales 2,600,00 100,00
0 0
North South
Return on sales (ROS) 6.92% 40.00
%
Investment turnover 1.30 0.50
(ITO)
ROI (ROS x ITO) 9.0% 20.0%
ROI and New Projects Example
Suppose that Altus has a minimum required rate of return
for all investments of 10%. Each division is considering a new
project. The expected return and initial investment of each
project is shown below. If ROI is used to evaluate division
performance, will each division accept or reject the new project?
Are these decisions in line with the best interests of Altus?
North South
Project income $7,500 $2,25
0
Project $80,000 $15,00
investment 0
Project ROI 9.38% 15.00
%

North will decide to accept the project because it will increase


division ROI. However, this is not in line with the organization’s
best interests because investments with an ROI less than 10% should
not be accepted.
South will decide to reject the project because it will decrease
division ROI. However, this is not in line with the organization’s
best interests because investments with an ROI exceeding 10%
should be accepted.
6. Residual Income (RI)
• RI is operating income less the
minimum required operating
income given the segment’s
investment in assets.
Required Average
RI = Operating rate of operati
income - ng
X return assets

• RI removes the incentive for


business segment managers to
make project investment decisions
based on a comparison of segment
ROI and project ROI.
RI Example
Altus Industries has two divisions, North and South. Given the
information below, compute the RI for each division. Suppose
that Altus has a minimum required rate of return of 10%. How
is this related to ROI?

North South
Operating income $180,000 $40,00
0
After-tax operating 120,000 24,000
income
Average operating 2,000,00 200,00
assets 0 0
Average current 400,000 36,000
liabilities
Net sales 2,600,00 100,00
0 0

North RI = $180,000 – 10% x $2,000,000 =


($20,000) South RI = $40,000 – 10% x $200,000 =
$20,000

North had an ROI less than the 10% minimum required, which
translates to a negative residual income. South’s ROI exceeded
the 10% minimum, so it had a positive RI.
RI and New Projects Example
If RI is used to evaluate division performance, will each division
accept or reject the new project? Are these decisions in line with
the best interests of Altus? The minimum required rate of return
for all investments of 10%.
North South
Project income $7,500 $2,25
0
Project $80,00 $15,00
investment 0 0
Project ROI 9.38% 15.00
%

North would reject the project because $7,500 – 10% x $80,000 < 0. If
North accepted the project, its new RI would be:
[$180,000 + $7,500] – 10% x [$2,000,000 + $80,000] = ($20,500).

South would accept the project because $2,250 – 10% x $15,000 > 0. If
South accepted the project, its new RI would be:
[$40,000 + $2,250] – 10% x [$200,000 + $15,000] = $20,750.
Each division’s decision is in line with Altus’ best interest.
7. Economic Value Added (EVA®)
• EVA® is a residual income calculation
with specific definitions of income,
investment and rate of return.
• Income is defined as “adjusted”
after-tax operating income.
• The required rate of return is defined
as the weighted average cost of capital
(WACC).
• Operating assets is defined as
“adjusted” total assets less current
liabilities.
• EVA ® ’s “ adjustments” are specific
to the organization’s structure and
goals.
EVA® Example
Altus Industries has two divisions, North and South. Given the
information below, compute the EVA® for each division.
Assume that the North Division has a WACC of 5% and that
South Division has a WACC of 18%.

North South
Operating income $180,000 $40,00
0
After-tax operating 120,000 24,000
income
Average operating 2,000,00 200,00
assets 0 0
Average current 400,000 36,000
liabilities
Net sales 2,600,00 100,00
0 0

North EVA® = $120,000 – 5% x [$2,000,000 - $400,000] = $40,000


South EVA® = $24,000 – 18% x [$200,000 - $36,000] = ($5,520)
2.6Life-Cycle Costing (LCC)
 Life-cycle costs are the total cost to the
organization for the ownership and
acquisition of the product over its full life.
This includes the cost of R&D,
production, operation, support, and,
where applicable, disposal.
A typical breakdown description might
include:
 R&D costs: The cost of feasibility
studies; cost-benefit analyses;
system analyses; detail design and
development; fabrication, assembly,
and test of engineering models;
initial product evaluation; and
associated documentation. 1-32
 Production cost: The cost of
fabrication, assembly, and testing of
production models; operation and
maintenance of the production
capability; and associated internal
logistic support requirements,
including test and support equipment
development, spare/repair p a r t s p r o
visioning, technical data
development, training, and entry of
items into inventory.
 Constructioncost: Thecos
t o f n e w manufacturing facilities or
upgrading existing structures to
accommodate production and
operation of support requirements. 1-33
 Operation and maintenance cost: The
cost of sustaining operational
personnel and maintenance support;
spare/repair parts and related
inventories; test and support
equipment maintenance;
transportation and handling;
facilities, modifications, and
technical data changes; and so on.
 Product retirement and phase out
cost: The cost of phasing the product
out of inventory due to
obsolescence or wear out, and
subsequent equipment item
recycling and reclamation as
appropriate.
1-34
Life-cyclecostanalysis
i s t h e systematic analytical
p r o c e s s of evaluating various
alternative courses of action early
on in a project, with the objective
of choosing the best way to
employ scarce resources.
 Life- cycle cost is employed in
the e v a l u a t i o n o f a l t e r n
ative designconfigurat
i o n s , a l t e r n a t i v e
manufacturing methods,
alternative support schemes, and
so on.
1-35
Life Cycle cost analysis process
includes:

Defining the problem (


w h a t information is needed).
 Defining the requirements of
the cost model being used.
 Collecting historical data–
cost relationships.
 Developing estimate and
test results.
1-36
Successful application of LCC will:

 Provide downstream
resource impact visibility.
 Provide life-cycle cost
management
 Influence R&D decision-making
 Support downstream
strategic budgeting.
1-37
There are also several limitations to life-cycle
cost analyses. They include:
 The assumption that the
product, as known, has a
finite life-cycle.
 A high cost to perform,
which may not be
appropriate for low-
cost/low-volume production.
 A high sensitivity to
changing requirements.
1-38
 Life-cycle costing requires that early
estimates be made. The estimating
method selected is based on the
problem context (i.e., decisions to be
made, required accuracy, complexity of
the product, and the development
status of t h e p r o d u c t ) a n d t h e
o p e r a t i o n a l considerations (i.e.,
market introduction date, time
available for analysis, and available
resources).
 The estimating methods available
can be classified as follows:
1-39
a. Informal estimating
methods
 i. Judgment based on experience:
 When using the subjective method,
the estimator relies on his experience
of similar projects to give a cost
indication based largely on ‘hunch’.
Geographical and political factors as
well as the more obvious labour and
material content must be taken into
account. Such an approximate method
of estimating is o f t e n g i v e n t h e
d i s p a r a g i n g n a m e o f
‘guesstimating’.
1-40
 ii. Analogy.
 When a new project is very similar to
another project recently completed, a quick
comparison can be made of the salient
features. This method is based on the costs
of a simplified schedule of major components
which were used on previous similar jobs. It
may even be possible to use the costs of a
similar sized complete project of which one
has had direct (and preferably recent)
experience. Due allowance must clearly be
made for the inevitable minor differences,
inflation and other possible cost escalations.
 SWAG method
 ROM method
 Rule-of-thumb method
b. Formal estimating m.ethods
 Detailed (from industrial
engineering standards):
 Parametric(statistical):Statist
ical
database can provide
expected values which
requires parametric cost
relationships to be established.
1-42
 Life-cycle cost analysis is an integral
part of strategic planning since today’s
decision will affect tomorrow’s actions.
 Yet there are common errors made
during life-cycle cost analyses.
 ● Loss or omission of data
 ● Lack of systematic structure
 ● Misinterpretation of data
 ● Wrong or misused techniques
 ● A concentration on insignificant facts
 ● Failure to assess uncertainty
 ● Failure to check work
 ● Estimating the wrong items…..END…… 1-43

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